BREAKING DOWN 'Dark Cloud Cover'

The Dark Cloud Cover pattern involves a large black candle forming a "dark cloud" over the preceding bullish trend. As with a bearish engulfing pattern, bulls push the price higher at the open, but bears take over later in the session and push the price sharply lower. The "takeover" of the trend is a sign that there could be a near-term bearish reversal.

The five criteria for the Dark Cloud Cover pattern are:

An existing bullish uptrend.

A bullish candle within that uptrend.

A gap up on the following day.

The gap up turns into a bearish candle.

The bearish candle closes below the midpoint of the previous bullish candle.

The Dark Cloud Cover pattern is further characterized by white and black candlesticks that have long real bodies and relatively short or non-existent shadows. These attributes suggest that the move lower was both highly decisive and significant in terms of price movement. Traders might also look for a conformation in the form of a bearish candle following the pattern.

Most traders use the Dark Cloud Cover pattern in conjunction with other forms of technical analysis as confirmation. For example, traders might look for a relative strength index (RSI) greater than 70.0, which provides a confirmation that the security is overbought. A trader may also look for a breakdown from a key support level following a Dark Cloud Cover pattern as a sign of a longer-term downtrend.

Example of Dark Cloud Cover

The following chart shows an example of the Dark Cloud Cover pattern in the VelocityShares Daily 2X VIX Short Term ETN (TVIX):

Chart courtesy of StockCharts.com.

In this example, the Dark Cloud Cover occurs when the third bullish candle is proceeded by a bearish candle that opens higher and closes below the midpoint of the bullish candle. The pattern successfully predicted a downturn in the following session where the price moved nearly seven percent lower. Traders might watch for a further fall in the price following the confirmation.

The trader might set a stop-loss point at the midpoint of the second candle in the Dark Cloud Cover pattern - or about $9.75 in this case. A take-profit point might be set at the reaction low at around $7.00, where there could be support for the bulls to make another attempt at pushing the price higher.